Joint Ventures Reduce the Risk of Major Capital Investments

In many industries, the capital required to build an asset of minimum efficient scale is growing. For instance, the cost of building and equipping a leading-edge semiconductor fab has climbed to $7 billion, as the technology required to make more advanced chips is getting more complex. The cost of building an oil rig has increased steadily, to more than $600 million, due to raw materials and labor cost increases, growing technical challenges, steeper regulatory requirements, and speculative building. Driven by economies of scale, container ship size has been increasing for decades, with the largest ships now costing roughly $200 million. Building a large-scale biopharmaceutical facility requires up to $500 million. The latest nuclear reactor designs, promising higher safety, longer operating life, and lower operating costs, cost up to $25 billion after factoring in the huge budget overruns.

This all presents CEOs with a tough dilemma. On the one hand, getting a payback from such huge investments is becoming harder and riskier in view of slow economic growth, excess industrial capacity, erratic external factors, and investment “lumpiness” — that is, the high fixed costs of building such an asset and the low probability that it could be redeployed to another use if business imperatives change.

But on the other hand, in order to safeguard the company’s future competitiveness, CEOs may have no other choice than to invest now. If a company does not invest, it faces several problems: lagging behind competitors in terms of production technology; being unable to meet customer needs for better-performing or cheaper products; not having facilities and equipment ready by the time demand picks up again; or failing to comply with stricter regulatory requirements for safety or emissions.

These conflicting pressures are especially present when the product provided by the asset is not very differentiating (think, for instance, of commodity steel products or container shipping services). To escape this quandary, a number of companies are considering alternative asset ownership and operation models, whose objective is to reduce capital outlays, investment risk, or both. The common idea behind these models is that the company does not have to be the (full) owner of the asset to be its (sole) operator.

Model 1: Virtual operator. In this model, an operator company does not invest in proprietary physical assets, instead renting capacity from an integrated owner-operator company. This is the virtual network operator (VNO) model used by the telecommunications sector. The virtual operator purchases bulk network capacity from an integrated telecom carrier while retaining a separate commercial identity. The integrated carrier gets incremental revenues from its excess capacity. The model can be a win-win as long as the two companies address different customer segments. For example, Lycamobile, a big mobile VNO, focuses on expatriate communities looking for low-cost international pay-as-you-go calls in 19 countries.

Model 2: Asset capacity pooling. Two companies that own and operate similar assets pool the capacity of their respective assets in order to increase utilization. For example, in 2015, Maersk and MSC, the world’s two largest liner shipping companies, established 2M, a 10-year vessel sharing agreement covering 193 vessels. Given the two companies’ complementary shipping schedules, services, and vessels, the agreement allows them to provide greater product options to customers at substantially lower operating cost.

Model 3: Joint venture of similar assets. Two companies transfer selected similar assets into a joint venture in order to support the orderly management of capacity in their industry and reduce the risk of prices spiraling downward. This is especially relevant when overall demand is declining and chronic overcapacity looms but continual investment in new technology remains important and capacity investment is lumpy. For example, in 2010, Corelio and Concentra, two European media companies, established Coldset Printing Partners, a joint venture (JV) for their newspaper printing assets. In the meantime, the JV has also started doing contract printing for third parties.

Model 4: Joint venture of complementary assets. A company sets up a joint venture with a partner that has complementary assets and capabilities, in order to limit up-front investments, speed up market entry, and reduce risk. For example, Ageas, a large European insurance company, has been using this model for its successful expansion into Asia. Ageas contributes its expertise in insurance product design, marketing, finance, and risk management, while the partner, often a well-embedded local financial institution, contributes its customer portfolio, distribution channel, brand, and relationships.

Model 5. Dual asymmetrical joint venture. A long-term financial investor (company A) and an industrial operator (company B) set up two joint ventures for an industrial asset: one that owns the asset, and another that operates the asset. Company A has a majority stake in the owner JV and a minority stake in the operator JV, and vice versa for company B. This setup provides company A with a steady dividend while allowing company B to reduce up-front capital outlays. For example, the global energy player ENGIE and its local partners apply it in the independent power production business in the Middle East.

Model 6: Cofunding of a third-party asset. Two companies cofund a third party building an asset, often in exchange for exclusive or preferential access to part of the capacity. For example, in 2012, Intel, TSMC, and Samsung — three large semiconductor manufacturers based in the U.S., Taiwan, and South Korea, respectively — agreed to fund a novel technology development program at ASML, a leading equipment manufacturer based in the Netherlands. They also took an equity stake in ASML of 15%, 5%, and 3%, respectively. The program creates risk sharing, and the results of ASML’s development programs will be available to every semiconductor manufacturer without restriction.

Model 7: Joint takeover of an asset. Two companies jointly invest in the takeover of a pricey asset, and subsequently benefit from its joint use. By doing so, they share the investment burden, reduce the lead time to build the asset from scratch, and possibly prevent the asset from falling into competitor hands. For example, in 2015, a consortium of German car manufacturers Audi, BMW, and Daimler took over Here, the digital mapping and location-intelligence business of the Finnish communications technology firm Nokia.

Guidelines for selecting an appropriate model

There are still other asset ownership and operation models, but the seven described above give an idea of the range of possibilities. The question is what investment strategy a given company should follow: don’t invest, invest alone, or coinvest? And if the company decides to coinvest, which ownership and operation model would be most appropriate? Three considerations should drive that decision.

Risks of missing the boat. Evaluate the technological, commercial, and regulatory risks of not investing in times of slack demand. For example, in some industries, such as carpet manufacturing, generations of production technology that improve productivity or produce ever more advanced products succeed each other rapidly. A company that misses one generation may find it hard to catch up, especially if it has also lost internal process engineering know-how. Another risk is the opportunity cost of not benefiting from lower investment costs. For example, the build cost of an oil rig at the bottom of the cycle may be 40% below the cost at its peak.

Benefits and risks of co-opetition. The alternative asset ownership and operation models often involve cooperation with a (potential) competitor, as illustrated by the above examples of 2M, ASML, and Here. The benefits and risks thereof have to be weighed. For example, when the product produced by the shared asset has the features of a “utility” (that is, undifferentiated output consumed in small increments, such as square meters of newspaper print), the risk is low. On the other hand, when you share an asset with a customer, you may unwittingly educate him, and thus create a potential future competitor.

Risk of breaching competition law. Cooperation with competitors entails the risk of triggering scrutiny by competition authorities. For example, the 2M vessel sharing agreement came into being after China’s Ministry of Commerce objected to the proposed P3 agreement, which included the third biggest liner shipping company. Likewise, the European Commission is barely willing to tolerate so-called “crisis cartels” that would be set up by industry in an attempt to reduce overcapacity in an orderly fashion.

In parallel to these three considerations, a company should assess opportunities to unshackle the business from the economics of lumpiness. In other words, could new technology or a new business concept enable a reduction in the minimum investment required to add one unit of capacity, just as cloud services have done for investments in IT processing power and storage space? Distributed power generation is a well-known example. Another example is microreactor technology, which is used in chemicals production processes; the scalable reactors promise fast and cost-effective production increases.

In summary, when economic growth is slow and investments costs are rising, even cash-rich companies understandably tend to put a brake on the addition or renewal of production capacity. Yet by doing so they risk lagging behind competitors when good times return. They may escape from this dilemma by adopting alternative asset ownership and operation models.

Herman Vantrappen is the Managing Director of Akordeon, a strategic advisory firm based in Brussels. He can be reached at herman.vantrappen@akordeon.com.

Daniel Deneffe is a strategy consultant and Professor of Strategy and Managerial Economics at Hult International Business School.